Editor’s Note:James Morphy is a partner at Sullivan & Cromwell LLP specializing in mergers & acquisitions and corporate governance. This post is based on a Sullivan & Cromwell publication. Another memorandum about the JOBS Act from Latham & Watkins LLP is available here.

On Tuesday, the U.S. House of Representatives passed H.R. 3606, the “Jumpstart Our Business Startups Act” (the “JOBS Act”), in the form passed last week by the U.S. Senate. The JOBS Act:

removes the prohibition on general solicitation in connection with transactions effected pursuant to Rule 506 or Rule 144A under the Securities Act of 1933, provided that sales are limited to qualifying investors;

alters the thresholds that trigger registration of an issuer’s securities under Section 12(g) of the Securities Exchange Act of 1934, including a different threshold for banks and bank holding companies;

provides, to a new category of “emerging growth companies”, relief from various requirements and other restrictions applicable to IPOs and (on a transitional basis, for up to five years) from certain reporting company obligations;

authorizes the SEC to increase the amount permitted to be raised in a Regulation A offering to $50 million in any 12-month period; and

adds a “crowdfunding” exemption to the Securities Act.

Many of the JOBS Act’s provisions will be effective upon signing by the President, which is expected later this week. Others will require SEC rulemaking.

Discussion

General Solicitation Provisions

The JOBS Act directs the SEC to amend Rule 506 of Regulation D and Rule 144A under the Securities Act to eliminate the prohibition on general solicitation in transactions effected under those rules. Specifically, Rule 506 must be amended to provide that the prohibition against general solicitation or general advertising shall not apply to offers and sales of securities made pursuant to that Rule, provided that all purchasers of the securities “are accredited investors”. The amendments must also require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, “using such methods as determined by the Commission”. Similarly, subsection (d)(1) of Rule 144A must be amended to provide that securities sold under that Rule may be offered to persons other than “qualified institutional buyers”, including by means of general solicitation or general advertising, provided that the securities are sold only to persons that the seller and any person acting on behalf of the seller reasonably believe is a qualified institutional buyer. The SEC is required to adopt these rule amendments not later than 90 days after enactment.

Current Rule 506 is available in offerings where, among other things, “the issuer reasonably believes” that no more than 35 purchasers are not “accredited investors”. Given the different language used in the JOBS Act’s provisions addressing Rule 506 and Rule 144A, it is unclear whether the SEC’s implementing rule changes will apply the “reasonable belief” standard to the condition to the new general solicitation provision in Rule 506 that all purchasers “are accredited investors”.

The JOBS Act does not amend the exemption from registration provided by Section 4(2) of the Securities Act itself. In particular, the new provisions permitting general solicitation do not, by their terms, apply to private placements that are conducted in reliance upon Section 4(2) but not in accordance with Rules 506 or 144A as revised. It is unclear whether these new provisions will have any effect on the Section 4(2) exemption, as it is interpreted by the SEC and the courts.

The JOBS Act also adds two new provisions to Section 4 of the Securities Act:

The first provides that offers and sales exempt under Rule 506 of Regulation D (as revised pursuant to the Jobs Act) “shall not be deemed public offerings under the Federal securities laws as a result of general advertising or general solicitation”. This would appear to permit issuers relying on the Section 3(c)(1) and Section 3(c)(7) exemptions from registration under the Investment Company Act of 1940 to avail themselves of the JOBS Act’s general solicitation relief in connection with Rule 506 offerings.

The second provides an exemption from broker-dealer registration for certain online or other trading platforms or matching services through which Rule 506 offerings are conducted, subject to specified conditions. Among other things, those who wish to rely on the exemption would not be permitted to receive compensation in connection with the purchase or sale of the securities.

Registration Triggers Under Section 12(g) of the Exchange Act

Section 12(g)(1) of the Exchange Act currently requires an issuer that has a class of equity security (other than an exempted security) held of record by 500 or more persons to register that security with the SEC within 120 days after the last day of its first fiscal year in which the issuer had total assets exceeding $10,000,000. The JOBS Act raises the record holder threshold for registration:

for most issuers, to either (i) 2,000 persons or (ii) 500 persons who are not accredited investors; and

for banks and bank holding companies, to 2,000 persons.

The JOBS Act also amends Section 12(g)(4) (which permits termination of registration of any class of securities held of record by less than 300 persons) and Section 15(d) (which similarly suspends periodic reporting obligations with respect to any class of securities held of record by less than 300 persons) to provide for termination or suspension of reporting obligations with respect to securities of a bank or bank holding company that are held of record by less than 1,200 persons. [1]

The JOBS Act also provides that, for all issuers, persons holding securities received pursuant to an employee compensation plan in transactions exempted from the registration requirements of Section 5 of the Securities Act (for example, because they were issued in a private placement under Regulation D or under Rule 701 under the Securities Act) will be excluded from the record holder count.

The SEC is required to (i) adopt safe harbor provisions for determining whether holders qualify for this employee compensation plan exclusion and (ii) examine whether new measures are needed to enforce the anti-evasion provision of Rule 12g5-1(b)(3), and to transmit its recommendations to Congress within 120 days after enactment. A Senate amendment that would have required the SEC to define “held of record” for purposes of Section 12(g) “to include beneficial owners” was not adopted. Subject to the specific exceptions noted above, the JOBS Act therefore does not change the SEC’s current method for determining the number of “record holders” under Section 12(g). In particular, the number of record holders of shares held through The Depository Trust Company will continue to be calculated by reference to the number of DTC participants through which shares are held, consistent with current SEC guidance, rather than the number of underlying beneficial owners.

Relief for “Emerging Growth Companies”

The JOBS Act creates a new category of “emerging growth companies”, or “EGCs”, and provides various forms of relief aimed at making it easier for these companies to undertake IPOs. An EGC is defined as any issuer that had total annual gross revenues of less than $1 billion2 during its most recently completed fiscal year, other than a company that completed its IPO on or before December 8, 2011. An EGC retains that status until the earliest of:

the last day of the fiscal year during which it had total annual gross revenues of $1 billion or more; [2]

the last day of the fiscal year following the fifth anniversary of the issuer’s IPO;

the date on which the issuer has, during the previous three-year period, issued more than $1 billion in non-convertible debt; or

the date on which the issuer is deemed to be a “large accelerated filer”, as defined in Rule 12b-2 under the Exchange Act (i.e., has been a reporting company for 12 months, has filed at least one annual report, and has a market value of equity securities held by non-affiliates of $700 million or more as of the most recently completed second fiscal quarter).

The JOBS Act grants EGCs the relief described below for as long as they retain that status. This relief will be available immediately upon the enactment of the JOBS Act.

Internal Controls Audit and Auditing Standards

An EGC is excluded from Section 404(b) of the Sarbanes-Oxley Act of 2002 (the “Sarbanes-Oxley Act”), which requires the auditors of a public company to attest to and report on the company’s internal control over financial reporting. EGCs will remain subject to the management report requirements of Sarbanes- Oxley Section 404(a). The JOBS Act also amends Section 103(a)(3) of the Sarbanes-Oxley Act to provide that (i) any new rules that may be adopted by the PCAOB requiring mandatory audit firm rotation or changes to the auditor’s report to include auditor discussion and analysis (each of which is currently under consideration by the PCAOB) shall not apply to an audit of an EGC and (ii) any other future rules adopted by the PCAOB will not apply to audits of EGCs unless the SEC determines otherwise.

Disclosure Obligations

The JOBS Act amends Section 7(a) of the Securities Act to provide that an EGC need not present more than two years of audited financial statements in its IPO registration statement and need not present selected financial data pursuant to Item 301 of Regulation S-K (or, apparently, financial statements in any other registration statement) for any period prior to the earliest audited period presented in connection with its IPO. Current rules require three years of audited income statements, and five years of selected financial data. An EGC’s MD&A need only cover the periods for which it files financial statements. Moreover, an EGC is not required to comply with any new or revised financial accounting standard until such date as a private company (i.e., a company that is not an “issuer” as defined by Section 2(a) of the Sarbanes-Oxley Act) is required to comply with such new or revised accounting standard. Corresponding changes have been made to the Exchange Act, which relates to periodic reporting requirements of issuers. [3]

In addition, EGCs may comply with Item 402 of Regulation S-K, which requires extensive quantitative and qualitative disclosure regarding executive compensation, by disclosing the more limited information required of a “smaller reporting company”.

The JOBS Act also exempts EGCs from the following additional compensation-related disclosure provisions that were imposed on U.S. public companies pursuant to the Dodd-Frank Act:

the advisory “say-on-pay” vote on executive compensation required under Section 14A(a) of the Exchange Act;

the Section 14(i) requirements for disclosure relating to the relationship between executive compensation and financial performance of the issuer; and

the requirement of Dodd-Frank Act Section 953(b)(1), which will require disclosure as to the relationship between CEO and median employee pay.

The say-on-pay and golden parachute provisions took effect in 2011 for U.S. public companies. The SEC has yet to propose rules implementing the latter two disclosure items, but is expected to do so this year.

Issuance of Research on ECGs

The JOBS Act amends Section 2(a)(3) of the Securities Act to provide a blanket exemption for any broker-dealer research report on an EGC that is the subject of a proposed registered public offering of common equity securities, whether issued before or after filing, even if the broker-dealer is participating in the registered offering. This change would allow such research reports to be published or distributed without violating the registration requirements of Section 5 of the Securities Act. [4] Currently, such research reports could not be issued in connection with an IPO.

The JOBS Act also amends Section 15D of the Exchange Act to prohibit the SEC or FINRA from adopting or maintaining rules that, in the context of a common equity IPO of an EGC, (i) restrict, based on functional role, which associated persons of a broker-dealer may arrange for communications between a securities analyst and a potential investor; or (ii) restrict a securities analyst from participating in any communications with the management of an EGC that is also attended by any other associated person of the broker-dealer whose functional role is other than as a securities analyst. The JOBS Act also prohibits the SEC or FINRA from adopting or maintaining any rule prohibiting a broker-dealer from publishing or distributing any research report or making a public appearance, with respect to the securities of an EGC, within prescribed time frames following an IPO or prior to the expiration of lock-up agreements after the IPO. These provisions override, in this context, certain provisions of NASD Rule 2711. [5]

Other Changes for Emerging Growth Companies

Section 5 of the Securities Act is amended to add a “testing-the-waters” provision, permitting an EGC to engage in oral or written communications with potential investors that are qualified institutional buyers or institutional accredited investors to determine whether those investors might have an interest in a contemplated securities offering, either prior to or following the date of filing of a registration statement. It is unclear whether this new provision would extend to communications by a prospective underwriter on behalf of an EGC.

The JOBS Act amends Section 6 of the Securities Act to permit any EGC to confidentially submit to the SEC a draft IPO registration statement for review prior to public filing, and provides that the SEC shall not be compelled to disclose any such filing. However, the EGC is required to file on EDGAR, not less than 21 days before commencing its roadshow, the initial confidential submission and all amendments thereto (it is unclear whether SEC comment letters and issuer responses issued and submitted before filing will also be placed on EDGAR). This 21-day requirement may limit the practical utility of the confidential submission process for many issuers.

Required Studies

The JOBS Act requires the SEC to conduct a study examining the transition to trading and quoting securities in one-penny increments, also known as decimalization, and its impact on the number of IPOs and the liquidity for securities of small and mid-cap companies. The SEC must submit its findings to Congress not later than 90 days after enactment. If the SEC determines that the securities of EGCs should be quoted and traded using a minimum increment of greater than $0.01, it may, by rule not later than 180 days after enactment, designate a minimum increment for the securities of EGCs which is greater than $0.01 but less than $0.10.

The JOBS Act also requires the SEC to conduct a review of Regulation S-K to determine how its requirements can be updated to modernize and simplify the registration process and reduce the associated costs and burdens on EGCs. The SEC is directed to submit a report of this review to Congress, including specific recommendations on how to streamline the registration process, within 180 days after enactment.

Regulation A Amendments

The JOBS Act amends Section 3(b) of the Securities Act to permit the SEC to amend Regulation A to, among other things, increase the aggregate offering amount of securities offered and sold within any 12-month period in reliance on such exemption from $5 million to $50 million.

Securities offered pursuant to Regulation A are not “covered securities”, for purposes of preemption of state securities, or “Blue Sky”, laws under Section 18 of the Securities Act. The JOBS Act directs the U.S. Comptroller General to conduct a study on the impact of state Blue Sky laws on offerings made under Regulation A, and to submit a report on the study to the relevant House and Senate Committees not later than three months after enactment.

Crowdfunding Exemption

The JOBS Act amends the Securities Act by adding a new Section 4(6), providing an exemption from Securities Act registration for transactions involving the offer or sale of securities by an issuer (including all entities controlled by or under common control with the issuer), provided that:

the aggregate amount sold to all investors, including any amount sold in reliance on such exemption, during the 12-month period preceding the date of such transaction, is not more than $1,000,000;

the aggregate amount sold to any investor, including any amount sold in reliance on such exemption during the 12-month period preceding the date of such transaction, does not exceed (i) the greater of $2,000 or 5 percent of the annual income or net worth of such applicable, not to exceed a maximum aggregate amount sold to that investor of $100,000, if either the annual income or net worth of the investor is equal to or more than $100,000;

the transaction is conducted through a broker or funding portal [6] that complies with the requirements of newly adopted Section 4A(a); and

the issuer complies with the requirements of Section 4A(b).

Pursuant to Section 4A(a), any person acting as an intermediary in a transaction effected pursuant to Section 4(6) must, among other things:

register with the SEC as a broker or a funding portal;

register with any applicable self-regulatory organization;

ensure that all investors positively affirm their understanding that they are risking the loss of their entire investment and can bear such a loss, and answer questions demonstrating their understanding of risk and illiquidity associated with the investment;

obtain a background history check for the directors, officers and holders of more than 20% of the outstanding equity of the issuer; and

Similarly, an issuer that offers or sells securities pursuant to Section 4(6) must, in accordance with newly adopted Section 4A(b), comply with various requirements, such as

file with the SEC and provide to investors and the relevant broker or funding portal certain information about the issuer, including a description of its business and financial condition, financial statements, intended use of proceeds, and ownership and capital structure;

not advertise the terms of the offering other than through notices that direct investors to the funding portal or broker;

not compensate any person to promote the offering in a manner not prescribed by the SEC;

at least annually file with the SEC and provide to investors financial statements in compliance with rules that the SEC may establish; and

comply with such other requirements as the SEC may prescribe.

As a limitation, Section 4(6) will not apply to transactions involving the offer or sale of securities by any issuer that:

is not organized under and subject to the laws of a State or territory of the United States or the District of Columbia;

is subject to the requirement to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act;

is an investment company, or is excluded from the definition of investment company by Section 3(b) or Section 3(c) of the Investment Company Act of 1940; or

does not satisfy standards that the SEC, by rule or regulation, determines appropriate.

The JOBS Act requires the SEC to establish disqualification provisions under which an issuer or an also amends Section 12(g) of the Exchange Act to provide that the SEC shall adopt rules exempting, conditionally or unconditionally, securities acquired pursuant to an offering made under Section 4(6) from the registration provisions of that subsection.

Any securities issued pursuant to Section 4(6) will be subject to transfer restrictions and may not be transferred during the one-year period beginning on the date of purchase, unless such securities are transferred to the issuer, to an accredited investor, as part of a registered offering, or to a member of the family of the purchaser or the equivalent, or in connection with the death or divorce of the purchaser or other similar circumstance, in the discretion of the SEC.

An investor who purchases a security in a transaction exempted by the provisions of Section 4(6) may bring an action against an issuer [8] under Section 4A(c) for rescission or damages. Any such action shall be subject to the provisions of Section 12(b) and Section 13 of the Securities Act, as if the liability were created under Section 12(a)(2).

The Act requires the SEC to issue rules implementing Section 4(6) and Section 4A not later than 270 days after enactment.

Endnotes

[1] The registration requirements of Section 12(b), which apply to securities listed on a national securities exchange, are not affected by the changes to Sections 12(g) and 15(d).(go back)

[2] This amount is to be indexed for inflation every five years by the SEC.(go back)

[3] An EGC may elect to forego this right to follow “private company” accounting standards, by so stating in its first SEC filing, but in that case the EGC will be required to comply with all accounting standards on a “public company” basis. With regard to any other exemption afforded to EGCs by the JOBS Act, an EGC may elect to forego the exemption and comply with the requirements that apply to non- EGCs.(go back)

[4] The change would also appear to exempt such research reports from the disclosure liability provisions of Section 12(a)(2) of the Securities Act, but not from other liability provisions such as Section 17 of the Securities Act and Rule 10b-5 under the Exchange Act.(go back)

[5] They would not, on the other hand, affect the 2003 Global Research Analyst Settlement.(go back)

[6] The term “funding portal” means any person acting as an intermediary in a transaction involving the offer or sale of securities for the account of others, solely pursuant to Section 4(6) of the Securities Act, that does not–

(A) offer investment advice or recommendations;
(B) solicit purchases, sales, or offers to buy the securities offered or displayed on its website or portal;
(C) compensate employees, agents, or other persons for such solicitation or based on the sale of securities displayed or referenced on its website or portal;
(D) hold, manage, possess, or otherwise handle investor funds or securities; or
(E) engage in such other activities as the SEC, by rule, determines appropriate.

The JOBS Act directs the SEC to issue a rule exempting a funding portal from registration as a broker-dealer under the Exchange Act, subject to certain qualifications.(go back)

[7] Each intermediary that participates in a transaction effected pursuant to Section 4(6) will be required to make such efforts as the SEC may determine are appropriate to ensure that no investor in a 12-month period has purchased securities offered pursuant to Section 4(6) which, in the aggregate, from all issuers, exceed the individual investment limits set forth in the second bullet point of the first paragraph under “Crowdfunding Exemption”.(go back)

[8] For purposes of Section 4A(c), the term “issuer” includes any person who is a director or partner of the issuer, and the principal executive officer or officers, principal financial officer, and controller or principal accounting officer of the issuer (and any person occupying a similar status or performing a similar function) that offers or sells a security in a transaction exempted by the provisions of section 4(6), and any person who offers or sells the security in such offering.(go back)

This creates an opportunity for millions of people to use technology-bsed economic development principles to create a new ecosystem based upon local companies acting globally. Look at Germany’s success.

[…] One major facet of the law is the creation of a category of “emerging growth companies,” or “ECGs.” An ECG is defined as any issuer that had total annual gross revenues of less than $1 billion in the last fiscal year. An ECG retains that status for up to five years after its initial public offering (it may lose that status earlier if revenues reach more than $1 billion, if it issues more than $1 billion in debt or floats more than $700 million in stock). Companies that went public before Dec. 8, 2011 do not qualify for ECG status. […]